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entitled 'Mutual Funds: Assessment of Regulatory Reforms to Improve the
Management and Sale of Mutual Funds' which was released on March 10,
2004.
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Testimony:
Before the Committee on Banking, Housing and Urban Affairs, U.S.
Senate:
United States General Accounting Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EST:
Wednesday, March 10, 2004:
Mutual Funds:
Assessment of Regulatory Reforms to Improve the Management and Sale of
Mutual Funds:
Statement of David M. Walker Comptroller General of the United States:
GAO-04-533T:
GAO Highlights:
Highlights of GAO-04-533T, a report to Chairman, Senate Committee on
Banking, Housing and Urban Affairs
Why GAO Did This Study:
Since September 2003, widespread allegations of abusive practices
involving mutual funds have come to light. An abuse called late trading
allowed some investors, at times in collusion with pension plan
intermediary, broker-dealer, or fund adviser staff, to profit at other
investors’ expense by submitting orders for fund shares to receive that
day’s price after the legal cutoff. Other investors were allowed to
conduct market timing trades to take advantage of stale prices used by
funds to calculate their net asset values at funds with stated policies
against such trading. SEC and other regulators have responded with
numerous proposals for new or revised practices. Based on a body of
work that GAO has conducted involving mutual funds, GAO analyzed and
provides views on proposed and final rules involving (1) fund pricing
and compliance practices intended to address various mutual fund
trading abuses that have come to light recently, (2) fund boards’
independence and effectiveness, (3) fund adviser compensation of broker-
dealers that sell fund shares, and (4) additional actions regulators
could take to further improve transparency and investor understanding
of the fees they pay.
What GAO Found:
GAO commends SEC and other regulators for their swift regulatory
response to recently revealed abusive mutual fund practices. However,
some proposed actions need to be thoroughly assessed to ensure
equitable treatment for all investors and others will need to be
reinforced with enhanced compliance, enforcement, and investor
education programs to be truly effective. In particular, to prevent
further late trading, SEC has proposed that all mutual fund orders be
received by funds or designated processors by 4:00 p.m. Eastern Time,
but this action may unfairly impact some retail investors that place
orders through financial intermediaries. Although GAO supports in the
short run the proposed hard 4:00 p.m. close as a way of increasing the
certainty that all orders have been legitimately received, GAO believes
that SEC should continue to work with industry participants, including
pension plan intermediaries, to address concerns that the hard close
would adversely affect investors that use such intermediaries. To
address market timing, SEC is proposing that funds make greater
disclosure of market timing, securities pricing, and portfolio
disclosure policies. GAO supports these steps and encourages regulators
to educate investors about the importance of such disclosures.
To improve mutual fund corporate governance and oversight, SEC has also
proposed increasing the proportion of independent directors to 75
percent and to require independent chairs. SEC is also proposing that
fund advisers appoint compliance officers that report to fund boards.
GAO sees these actions as giving increased prominence to independent
members on fund boards of directors and providing them with additional
tools to effectively oversee fund practices. However, additional
actions may be needed to ensure that independent directors have no
relationships with the fund adviser or its personnel that could impair
their independence. SEC and other regulators have also proposed that
the broker-dealers that sell fund shares make more extensive
disclosures about payments they receive from fund advisers. SEC is also
seeking comments on how to revise the fees they charge investors that
also compensate broker-dealers for selling fund shares. GAO supports
these actions as increasing the transparency of these costs to
investors but recognizes that the effectiveness of these proposals
could be enhanced by expanded compliance and investor education
programs.
SEC is also seeking information on how fund advisers use investor
dollars to obtain research under a practice called soft dollars. Given
the increased spotlight that Congress and regulators are placing on the
mutual fund industry, GAO believes the time is right to more
effectively address the conflicts of interest created by soft-dollar
arrangements. In addition, GAO identifies further actions that could be
taken to improve disclosure of mutual fund fees to enhance competition
among funds on the basis of the fees that are charged to shareholders.
What GAO Recommends:
In this statement, GAO raises a number of issues for regulators to
consider that could enhance the effectiveness of proposed rule changes.
www.gao.gov/cgi-bin/getrpt?GAO-04-533T.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Richard J. Hillman
(202) 512-8678 or hillmanr@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss GAO's work assessing the
transparency of mutual fund fees and other fund practices and to
discuss the various proposed or anticipated regulatory reforms designed
to improve the management and sale of mutual funds. In the last 20
years, mutual funds have grown from under $400 billion to over $7.5
trillion in assets and have become a vital component of the financial
security of the more than 95 million American investors estimated to
own mutual funds. These funds have also grown to represent a
significant portion of American's retirement wealth with 21 percent of
the more than $10 trillion in pension plan assets now invested in
mutual funds.[Footnote 1] As a result, ensuring that mutual funds have
sound governance and trading practices has never been more important.
Recent actions by the Securities and Exchange Commission (SEC) and NASD
would establish new procedures to protect shareholders against recently
disclosed abusive trading practices, revise the structure and duties of
the boards of directors that oversee funds, and place new
responsibilities on the mutual fund and brokerage industries.[Footnote
2]
Based on the work that we have performed over the last year, I will
discuss problems we have seen within the mutual fund and brokerage
industries and provide our views on the various SEC and NASD-proposed
regulatory reforms.[Footnote 3] Specifically, I will discuss proposed
and final rules involving (1) fund pricing and compliance practices
intended to address various mutual fund trading abuses that have come
to light recently, (2) fund boards' independence and effectiveness, and
(3) fund advisers compensation of broker-dealers that sell fund shares.
In addition I will discuss additional actions regulators could take to
further improve transparency and investor understanding of the fees
they pay.
In summary, we commend SEC and other regulators for their swift
regulatory response to recent revelations of abusive mutual fund
trading practices. We believe that many of the actions taken will
provide the proper incentives to industry participants to follow sound
practices and also provide regulators with additional compliance and
enforcement tools to ensure that participants are held accountable for
their behavior. However, some proposed actions need to be thoroughly
assessed to ensure equitable treatment for all investors. In
particular, while we agree that SEC's proposal to address late trading
abuses with a hard 4:00 p.m. close provides increased certainty of the
legitimacy of orders, we also recognize that there are wide-ranging and
divergent interests in today's marketplace that must be accommodated to
ensure that all retail and institutional investors are treated fairly.
As such, while we agree with SEC's proposal for addressing unlawful
late trading in the short run, we believe that SEC should continue to
work with the retirement plan community and cognizant federal agencies
to address concerns that this proposed rule may have certain adverse
implications for certain participants in retirement savings plans.
We also firmly agree with SEC's proposals to enhance the independence
and effectiveness of mutual fund boards. Giving increased prominence to
independent members on fund boards of directors and providing them with
additional tools to effectively oversee fund practices should go a long
way to improve the system of checks and balances needed to avoid future
trading abuses. However, additional attention could be afforded to
ensuring the adequacy of the definition of an "interested person" to
ensure that directors designated as independent directors are truly
independent. We also recognize that other proposals for improving
disclosures of mutual fund and brokerage trading practices will need to
be reinforced with enhanced compliance, enforcement, and investor
education programs if they are to be truly effective.
There are also other areas that warrant SEC's continued attention. SEC
is seeking information on how mutual fund investors pay for advice from
broker-dealers and how fund advisers use investor's dollars to obtain
research. However, given the increased spotlight Congress and
regulators are placing on the mutual fund industry, in our view, the
time is right to address various conflicts of interest created by soft-
dollar arrangements. In addition, further actions could be taken to
improve disclosure of mutual fund fees to enhance competition among
funds on the basis of the fees that are charged to shareholders.
In addition to the work I am discussing today, we are currently
studying other issues related to the security of workers' retirement
benefits. Pensions and retirement savings plans are an important source
of income for millions of retirees. As such, we are reviewing how
retirement savings plans, such as 401(k) plans, have been affected by
the mutual fund late trading and market timing scandals, and how SEC's
proposed rules to address these practices might affect plan
participants and plan administration. On the broader issue of corporate
governance, we also are currently studying what actions pension plan
fiduciaries take to address conflicts of interest in connection with
proxy voting issues. As large institutional shareholders, pension plans
have the opportunity to influence governance of funds and hold company
managers accountable for the business decisions they make.
Regulators Are Taking Actions to Address Abusive Mutual Fund Practices:
In reaction to allegations of widespread misconduct and abusive
practices involving mutual funds, regulators have responded with
various proposals. In early September 2003, the Attorney General of the
State of New York filed charges against a hedge fund manager for
arranging with several mutual fund companies to improperly trade in
fund shares and profit at the expense of other fund
shareholders.[Footnote 4] Since then, widening federal and state
investigations of illegal late trading and improper timing of fund
trades have involved a growing number of prominent mutual fund
companies and brokerage firms.
Late Trading and Market Timing Are Detrimental to Fund Long-Term
Shareholders:
One of the abuses that has come to light recently is late trading.
Under current rules, funds accept orders to sell and redeem fund shares
at a price based on the current net asset value, which most funds
calculate once a day at 4:00 p.m. Eastern Time.[Footnote 5] Many
investors, however, purchase mutual fund shares through other
intermediaries such as broker-dealers, banks, and retirement savings
plans. Instead of submitting hundreds or even thousands of individual
purchase and redemption orders each day, these intermediaries typically
aggregate orders received from investors and submit a single purchase
or redemption order that nets all the individual shares their customers
are seeking to buy or sell. Because this processing takes time, SEC
rules permit these intermediaries to forward the order information to
funds after 4:00 p.m.
However, late trading occurs when some investors are able to illegally
purchase or sell mutual fund shares after the 4:00 p.m. Eastern Time
close of U.S. securities markets, the time at which funds typically
price their shares. An investor permitted to engage in late trading
could be buying or selling shares at the current day's 4:00 p.m. price
with knowledge of developments in the financial markets that occurred
after 4:00 p.m. Such investors thus have unfair access to opportunities
for profit that are not provided to other fund shareholders.
The extent to which some investors were allowed to submit late trading
orders may have been significant. In September 2003, SEC sought
information from fund advisers and broker-dealers about their pricing
of mutual fund orders and late trading policies. SEC's preliminary
analysis of this information showed that more than 25 percent of the 34
major broker-dealers that responded had customers that still received
that day's price for orders they had placed or confirmed after 4:00
p.m. As of March 1, 2004, SEC had formally announced seven enforcement
cases involving broker-dealers and other firms that were allegedly
involved in late trading schemes; other cases may be forthcoming. We
will be initiating a review of the adequacy of SEC's enforcement
efforts and the sanctions that it can and has applied in these cases
and will be reporting separately on these issues later this year. In
addition, legislation is under consideration in the House of
Representatives that will expand SEC's enforcement capabilities by
raising the civil penalties for securities law violations, enhance the
investigative procedures available to SEC, and streamline the process
by which fines are disbursed among injured parties.[Footnote 6]
Another abuse that has come to light is known as market timing. Market
timing occurs when certain fund investors place orders to take
advantage of temporary disparities between the share value of a fund
and the values of the underlying assets in the fund's portfolio. For
example, U.S. mutual funds that use the last traded price for foreign
securities (whose markets close hours before the U.S. markets) to value
their portfolio when the U.S. markets close could create opportunities
for market timing if events that subsequently occurred were likely to
cause significant movements in the prices of those foreign securities
when their home markets reopen.
Market timing, although not currently illegal, can be unfair to long-
term fund investors because it provides the opportunity for selected
fund investors to profit from fund assets at the expense of long-term
investors. The following example illustrates how market timing
transactions can reduce the return to long-term shareholders of a fund.
Figure 1: Impact on Fund Net Asset Value (NAV) With and Without an
Investment By a Market Timer:
[See PDF for image]
Note: The figure shows how a hypothetical mutual fund is affected by an
increase in its portfolio assets with and without a market timer
transaction. In this example, a market timer invests $1,000 in the fund
on day 1 before a 10 percent rise in the value of the securities held
by the fund. On day 2 the market timer redeems the shares yielding a
reduction in the funds net assert value compared to its value without a
market timer transaction. The example assumes that the portfolio
manager is unable to invest the market timer's cash and thus that
amount does not help increase the fund's gain when the market rises.
[End of figure]
As shown in the figure, the loss to long-term holders of the fund in
this case is only $.01 per share. Although the amount by which a single
market timing transaction reduces a fund's overall return can be small,
repeated and large transactions over long periods of time can have a
greater cumulative effect. For example, one fund company whose staff
were accommodating market timing transactions by 10 different investors
estimated that these investors earned $22.8 million through their
trading and that these activities costs its funds $2.7 million over a
period of several years. In addition, the redemption fees that these
investors should have paid but did not, amounted to another $5 million.
Market timing may also have been widespread. According to testimony by
SEC's Director of Enforcement, although most mutual funds have policies
that discourage market timing, this strategy was popular among some
individuals and institutional traders who attempted to conceal their
identities from fund companies. He also stated that 30 percent of the
broker-dealers responding to an SEC information request reported
assisting customers in attempting to conduct market timing trades, by
using methods, such as breaking their orders into smaller sizes to
avoid detection by the fund companies. Of the twelve cases SEC formally
opened that involved market timing activities, including five cases
that also involved late trading, two have been settled. In the
settlement for one case that involved both late trading and market
timing, SEC ordered the firm to pay fines and disgorgements of $225
million. In the other case, SEC ordered the firm to pay $250 million in
fines and disgorgements. NASD also has taken various enforcement cases
against broker-dealers involving late trading and market timing,
including one in which a broker-dealer was fined $1 million and ordered
to provide restitution of more than $500,000 for failing to prevent
market timing of an affiliated firm's mutual funds.
Additional abusive practices associated with mutual funds have also
come to light. To facilitate late trading and market timing
arrangements, some fund advisers selectively disclosed information
about their funds' portfolio holdings to outsiders. They also allowed
these parties to late trade or conduct market timing in their funds.
For example, in one SEC case a fund manager allowed a hedge fund to
engage in market timing in a fund that he managed. The fund manager
also disclosed portfolio information to a broker that enabled brokerage
customers to conduct market timing transactions in the funds. In
another state-administered case, a hedge fund executive obtained
special trading privileges from several mutual fund companies that
allowed him to engage in late trading and market timing in those funds.
Rule Changes Could Prevent Late Trading and Discourage Market Timing,
but Some Investors Might Be Disadvantaged:
In addition to enforcement actions, SEC has also proposed amending
regulatory rules to address late trading, market timing, and selective
disclosure abuses. In December 2003, SEC proposed amending the rule
that governs how mutual funds price their shares and receive orders for
share purchases or sales. [Footnote 7] Since many of the cases of late
trading involved orders submitted through intermediaries, including
banks and pension plans not regulated by SEC, the proposed amendments
to its rules would require that orders to purchase or redeem mutual
fund shares be received by a fund, its transfer agent, or a registered
clearing agency before the time of pricing (that is, 4:00 p.m. Eastern
Time).[Footnote 8]
Many organizations that purchase mutual fund shares, particularly those
that administer retirement savings plans, have expressed concerns that
such a "hard close" would unfairly prohibit some of their participants
from receiving the same day's price on share purchases. Because
intermediaries generally combine individual investor orders and submit
single orders to funds to buy or sell, many officials at such firms are
concerned that the time required to complete this processing will not
allow them to meet the 4:00 p.m. deadline. In such cases, investors
purchasing shares from Western states or through intermediaries would
either have to submit their trades earlier than other investors in
order to receive the current day's price or receive the next day's
price. A letter commenting on SEC's proposal from two investor advocacy
groups indicated that implementing the hard close would relegate some
retail investors to the status of "second-class shareholders." Some
plan sponsor organizations and plan record keepers have also raised
concerns about the potential significant administrative costs
associated with adopting systems to accommodate the 4:00 p.m. hard
close and other proposed rules.
Because the hard close could affect some investors' ability to trade at
the current day's price, some groups have called on SEC to allow
industry participants to develop systems of internal controls that
would serve to ensure that intermediaries receive individual orders
before 4:00 p.m. With such controls in place, these orders could
continue to be processed after this time. However, SEC officials told
us that they were skeptical that any system that relies on internal
controls could not provide certainty that late trading was not
occurring because many of the late trading abuses happened at firms
that purportedly had such controls in place. However, SEC remains open
to the possibility of the development of systems that could reasonably
detect and deter late trading. In its proposals, SEC requests comments
on various approaches designed to prevent late trading. Such
protections could include a system that provides an electronic or
physical time-stamp on orders. Other possible controls could include
certifications that the intermediary had policies and procedures in
place designed to prevent late trades, or audits by independent public
accountants. Because multiple regulators oversee the operations of
these financial intermediaries, any assessment of the reasonableness of
recommended systems or controls would likely require effective
coordination.
SEC is also proposing to take actions to address market timing. On
December 11, 2003, SEC released a rule proposal to provide greater
transparency to funds' market timing policies. Specifically, SEC would
require mutual funds to disclose in their prospectuses the risks to
shareholders of the frequent purchase and redemption of investment
company shares, and fund policies and procedures pertaining to frequent
purchases and redemptions. The proposal also would require funds to
explain both the circumstances under which they would use fair value
pricing and the effects of using fair value pricing.[Footnote 9]
Another rule will require funds to adopt fair value pricing policies
that require funds among other things, to monitor for circumstances
that may necessitate the use of fair value pricing, establish criteria
for determining when market quotations are no longer reliable for a
particular portfolio security, and provide a methodology or
methodologies by which the funds determine the current fair value of a
portfolio security. Also, SEC is seeking comment in one of its
proposals for additional ways to improve the implementation of fair
value pricing. In addition, the proposal would require funds to
disclose policies and procedures pertaining to their disclosing
information on the funds' portfolio holdings, and any ongoing
arrangements to make available information about their portfolio
securities. These additional disclosures would enable investors to
better assess risks, policies, and procedures, and determine if a
fund's policies and procedures were in line with their expectations.
Disclosure of a fund's procedures in these areas would also allow SEC
to better examine a fund's compliance with its stated procedures and
hold fund managers accountable for their actions.
To further stem market timing, on March 3, 2004, SEC issued a proposed
new rule to require mutual funds to impose a 2-percent redemption fee
on the proceeds of shares redeemed within 5 business days of purchase.
According to the proposal, the proceeds from the redemption fees would
be retained by the fund, becoming a part of fund assets. In addition,
the proposal addresses the pass thru of information from omnibus
accounts maintained by intermediaries. Specifically, the proposal
identifies three alternatives for funds to ensure that redemption fees
are imposed on the appropriate market timers through the use of
Taxpayer Identification Numbers. On at least a weekly basis
intermediaries would be required to provide to the fund, purchase and
redemption information for each shareholder within an omnibus account
to enable the fund to detect market timers and properly assess
redemption fees. The rule is designed to require short-term
shareholders to reimburse funds for costs incurred as a result of
investors using short-term trading strategies, such as market timing.
The proposal would also include an emergency exception that would allow
an investor not to pay a redemption fee in the event of an
unanticipated financial emergency.
Unlawful late trading and certain market timing activities, which are
not currently illegal, can be unfair to long-term investors because
these activities provide the opportunity for selected fund investors to
profit from fund assets at the expense of fund long-term investors.
SEC's proposal to address late trading with a hard 4:00 p.m. close
appears, in the short-term, to be the solution that provides the most
certainty that all orders being submitted to the funds legitimately
deserve that day's price. However, we also recognize that this action
could have a significant impact on many investors, particularly those
in employer-based retirement savings plans, who own fund shares through
financial intermediaries. As a result, we urge the Commission to, as a
supplement to their planned action, explore alternatives to the hard
4:00 p.m. close more fully and to revisit formally the question of how
best to prevent late trading. Since some of the financial
intermediaries involved are either overseen by other regulators or, in
the case of third-party pension plan administrators, not overseen by
any regulator, any such assessment should include the development of a
strategy for overseeing the intermediary processing of mutual fund
trades. Having a sound strategy for oversight of the varied
participants in the mutual fund industry would ensure that all relevant
entities are held equally accountable for compliance with all
appropriate laws.
We also commend SEC for proposing to require that mutual funds more
fully disclose their market timing and portfolio disclosure policies.
By increasing the transparency of these policies, industry participants
will have the incentive to ensure that their policies are sound and
will provide investors with information that they can use to
distinguish between funds on the basis of these policies. The
disclosures will also provide regulators and others with information to
hold these firms accountable for their actions. However, such
disclosures would likely also require improving related investor
education programs to better ensure that investors understand the
importance of these new disclosures. We also support SEC's redemption
fee proposal as a means of discouraging market timing. Placing the
proceeds of the fee back in the fund itself helps to ensure that the
actions of short-term traders do not financially harm long-term
investors, including pension plan participants who hold such funds.
Regulators Are Taking Actions to Improve the Effectiveness of Mutual
Fund Boards of Directors:
Mutual fund boards of directors have a responsibility to protect
shareholder interests and SEC has issued various proposals to increase
the effectiveness of these bodies. In particular, independent
directors, who are not affiliated with the investment adviser, play a
critical role in protecting mutual fund investors. To improve the
independence of fund boards, SEC has issued various proposals to alter
the structure of these boards and task them with additional duties.
Directors Have a Role in Overseeing Fees:
Because the organizational structure of a mutual fund can create
conflicts of interest between the fund's investment adviser and its
shareholders, the law governing U.S. mutual funds requires funds to
have a board of directors to protect the interests of the fund's
shareholders. A fund is usually organized by an investment management
company or adviser, which is responsible for providing portfolio
management, administrative, distribution, and other operational
services. In addition, the fund's officers are usually provided,
employed, and compensated by the investment adviser. The adviser
charges a management fee, which is paid with fund assets, to cover the
costs of these services. With the management fee representing its
revenue from the fund, the adviser's desire to maximize its revenues
could conflict with shareholder goals of reducing fees. As one
safeguard against this potential conflict, the Investment Company Act
of 1940 (the Investment Company Act) requires mutual funds to have
boards of directors to oversee shareholder interests. These boards must
also include independent directors who are not employed by or
affiliated with the investment adviser.
As a group, the directors of a mutual fund have various
responsibilities and in some cases, the independent directors have
additional duties. In particular, the independent directors also have
specific duties to approve the investment advisory contract between the
fund and the investment adviser and the fees that will be charged.
Specifically, section 15 of the Investment Company Act requires that
the terms of any advisory contracts and renewals of advisory contracts
be approved by a vote of the majority of the independent directors.
Under section 36(b) of the Investment Company Act, investment advisers
have a fiduciary duty to the fund with respect to the fees they
receive, which under state common law typically means that the adviser
must act with the same degree of care and skill that a reasonably
prudent person would use in connection with his or her own affairs.
Section 36(b) also authorizes actions by shareholders and SEC against
an adviser for breach of this duty. Courts have developed a framework
for determining whether an adviser has breached its duty under section
36(b), and directors typically use this framework in evaluating
advisory fees. This framework finds its origin in a Second Circuit
Court of Appeals decision, in which the court set forth the factors
relevant to determining whether an adviser's fee is excessive.[Footnote
10] The court in this case stated that to be guilty of a breach under
section 36 (b), the fee must be "so disproportionately large that it
bears no reasonable relationship to the services rendered and could not
have been the product of arms-length bargaining." The standards
developed in this case, and in cases that followed, served to establish
current expectations for fund directors with respect to fees. In
addition to potentially considering how a fund's fee compared to those
of other funds, this court indicated that directors might find other
factors more important, including:
* the nature and quality of the adviser's services,
* the adviser's costs to provide those services,
* the extent to which the adviser realizes and shares with the fund
economies of scale as the fund grows,
* the volume of orders that the manager must process,
* indirect benefits to the adviser as the result of operating the fund,
and:
* the independence and conscientiousness of the directors.
Concerns Over Directors' Roles Exist:
Some industry experts have criticized independent directors for not
exercising their authority to reduce fees. For example, in a speech to
shareholders, one industry expert stated that mutual fund directors
have failed in negotiating management fees. The criticism arises in
part from the annual contract renewal process, in which boards compare
fees of similar funds. However, the directors compare fees with the
industry averages, which the experts claim provides no incentive for
directors to seek to lower fees. Another industry expert complained
that fund directors are not required to ensure that fund fees are
reasonable, much less as low as possible, but instead are only expected
to ensure that fees fall within a certain range of reasonableness.
In contrast, an academic study we reviewed criticized the court cases
that have shaped directors' roles in overseeing mutual fund fees. The
authors noted that these cases generally found that comparing a fund's
fees to other similar investment management services, such as pension
plans, was inappropriate as fund advisers do not compete with each
other to manage a particular fund. Without being able to compare fund
fees to these other products, the study's authors say that investors
bringing these cases lacked sufficient data to show that a fund's fees
were excessive.[Footnote 11]
Various Actions Taken or Proposed to Increase Board Effectiveness and
Mutual Fund Oversight:
In light of concerns over director roles and effectiveness, including
concerns arising from the recently alleged abusive practices, SEC has
taken various actions to improve board governance and strengthen the
compliance programs of fund advisers. To strengthen the hand of
independent directors when dealing with fund management, SEC issued a
proposal in January 2004 to amend rules under the Investment Company
Act to alter the composition and duties of many fund boards.[Footnote
12] These reforms include:
* requiring an independent chairman for fund boards of directors;
* increasing the percentage of independent directors from a majority to
at least seventy-five percent of a fund's board;
* requiring fund independent directors to meet at least quarterly in a
separate session; and:
* providing the independent directors with authority to hire employees
and others to help the independent directors fulfill their fiduciary
duties.
Under the Investment Company Act, only individuals who are not
"interested" can serve as independent directors. Section 2(a)(19) of
the Investment Company Act defines the term "interested person" to
include the fund's investment adviser, principal underwriter, and
certain other persons (including their employees, officers or
directors) who have a significant relationship with the fund, its
investment adviser or principal underwriter. Broker-dealers that
distribute the fund's shares or persons who have served as counsel to
the fund would also be considered interested. However, SEC has
suggested that Congress give it authority to fill gaps in the statute
that have permitted persons to serve as independent directors who do
not appear to be sufficiently independent of fund management. For
example, the statute permits a former executive of the fund's adviser
to serve as an independent director two years after the person has
retired from his position. This permits an adviser to use board
positions as a retirement benefit for its employees. The statute also
permits relatives of fund managers to serve as independent directors as
long as they are not members of the "immediate family" or affiliated
persons of the fund. In one case, SEC found that an uncle of the funds
portfolio manager served as an independent director of the fund. Giving
SEC additional rulemaking authority to define the term "interested
person" clearly seems appropriate.
As part of their proposal to alter the structure of fund boards, SEC is
also proposing that fund directors perform at least once annually an
evaluation of the effectiveness of the board and its committees. This
evaluation is to consider the effectiveness of the board's committee
structure and whether the directors have taken on the responsibility
for overseeing too many funds. The proposal also seeks to amend the
fund recordkeeping rule (rule 31a-2) to require that funds retain
copies of the written materials that directors consider in approving an
advisory contract under section 15 of the Investment Company Act.
According to the SEC proposal, the changes to board structure and
authority are designed to enhance the independence and effectiveness of
fund boards and to improve their ability to protect the interests of
the funds and fund shareholders they serve. Specifically, SEC noted
that commenters on a 2001 amendment believed that a supermajority of
independent directors would help to strengthen the hand of independent
directors when dealing with fund management, and help assure that
independent directors maintain control of the board in the event of
illness or absence of other independent directors. Also, SEC concluded
that (1) a boardroom culture favoring the long-term interests of fund
shareholders might be more likely to prevail if the board chairman does
not have the conflicts of interest inherent in his role as an executive
of the fund adviser, and (2) a fund board may be more effective when
negotiating with the fund adviser over matters such as the advisory fee
if it were not led by an executive of the adviser with whom it was
negotiating. SEC also noted that separate meetings of the independent
directors would afford independent directors the opportunity for frank
and candid discussion among themselves regarding the management of the
fund. In addition, it saw the use of staff and experts as important to
help independent directors deal with matters beyond their level of
expertise and give them an understanding of better practices among
mutual funds.
According to SEC's proposal, having fund directors perform self-
evaluations of the boards' effectiveness could improve fund performance
by strengthening the directors' understanding of their role and
fostering better communication and greater cohesiveness. This would
focus the board's attention on the need to create, consolidate, or
revise various board committees such as the audit, nominating, or
pricing committees. Finally, according to SEC staff, the proposed
additional recordkeeping rule would allow compliance examiners to
review the quality of the materials that boards considered in approving
advisory contracts.
In response to concerns regarding the adequacy of fund board review of
advisory contracts and management fees, on February 11, 2004, SEC also
released proposed rule amendments to require that funds disclose in
shareholders reports how boards of directors evaluate and approve, and
recommend shareholder approval of investment, advisory contracts. The
proposed amendments would require a fund to disclose in its reports to
shareholders the material factors and the conclusions with respect to
those factors that formed the basis for the board's approval of
advisory contracts during the reporting period. The proposals also are
designed to encourage improved disclosure in the registration statement
of the basis for the board's approval of existing advisory contracts,
and in proxy statements of the basis for the board's recommendation
that shareholders approve an advisory contract.
In addition, to facilitate better board governance and oversight, SEC
adopted requirements to ensure that mutual funds and advisers have
internal programs to enhance compliance with federal securities laws
and regulations. On December 17, 2003, SEC adopted a new rule that
requires each investment company and investment adviser registered with
the Commission to:
* adopt and implement written policies and procedures reasonably
designed to prevent violation of the federal securities laws,
* review those policies and procedures annually for their adequacy and
the effectiveness of their implementation, and:
* designate a chief compliance officer to be responsible for
administering the policies and procedures.
In the case of an investment company, the chief compliance officer
would report directly to the fund board. These rules are designed to
protect investors by ensuring that all funds and advisers have internal
programs to enhance compliance with federal securities laws.
To ensure that fund investment adviser officials and employees are
aware of and held accountable for their fiduciary responsibilities to
their fund shareholders, SEC also released a rule proposal in January
2004 that would require registered investment adviser firms to adopt
codes of ethics. According to the proposal, the rule was designed to
prevent fraud by reinforcing fiduciary principles that must govern the
conduct of advisory firms and their personnel. The proposal states that
codes of ethics remind employees that they are in a position of trust
and must act with integrity at all times. The codes would also direct
investment advisers to establish procedures for employees, so that the
adviser would be able to determine whether the employee was complying
with the firm's principles.
In addition to these actions, SEC had previously adopted rules that
became effective in April 2003 that require funds to disclose on a
quarterly basis how they voted their proxies for the portfolio
securities they hold. SEC also required client proxies to adopt
policies and procedures reasonably designed to ensure that the adviser
votes proxies in the best interests of clients, to disclose to clients
information about those policies and procedures, to disclose to clients
how they may obtain information on how the adviser voted their proxies,
and to maintain certain records relating to proxy voting. In adopting
these requirements, SEC noted that this increased transparency would
enable fund shareholders to monitor their funds' involvement in the
governance activities of portfolio companies, which may have a dramatic
impact on shareholder value. We are currently reviewing whether pension
plans have similar requirements to disclose their proxy voting
activities to their participants and will be reporting separately on
these issues later this year.
In our view, these SEC proposals should help ensure that mutual fund
boards of directors are independent and take an active role in ensuring
that their funds are managed in the interests of their shareholders.
Many fund boards already meet some of these requirements, but SEC's
proposal will better ensure that such practices are the norm across the
industry. Although such practices do not guarantee that funds will be
well managed and will avoid illegal or abusive behavior, greater board
independence could promote board decision making that is aligned with
shareholders' interests and thereby enhance board accountability. While
board independence does not require eliminating all nonindependent
directors, we have taken the position in previous work that it should
call for a supermajority of independent directors.[Footnote 13] Our
prior work also recognized that independent leadership of the board is
preferable to ensure some degree of control over the flow of
information from management to the board, scheduling of meetings,
setting of board agendas, and holding top management accountable. To
further ensure that board members are truly independent, we would
support the Congress giving SEC rulemaking authority to specify the
types of persons who qualify as "interested persons." Having compliance
officers report to fund boards and having advisers implement codes of
ethics should also provide additional tools to hold fund advisers and
boards accountable for ensuring that all fund activities are conducted
in compliance with legal requirements and with integrity.
Regulators Have Responded to Broker-Dealer Compensation Issues:
In addition to addressing alleged abusive practices, securities
regulators are also introducing proposals that respond to concerns over
how broker-dealers are compensated for selling mutual funds.
Specifically, SEC is seeking comments on how to revise a rule that
allows mutual funds to deduct fees to pay for the marketing and sale of
fund shares. In addition, to address a practice that raises potential
conflicts of interest between broker-dealers and their customers, SEC
and NASD have also proposed rules that would require broker-dealers to
disclose revenue sharing payments that fund advisers make to broker-
dealers to compensate them for selling fund shares. SEC has also
recently proposed banning a practice called directed brokerage that, if
adopted, would prohibit funds from using trading commissions as an
additional means of compensating broker-dealers for selling their
funds.
12b-1 Fees Have Increased Investor Choice but Alternatives Could
Provide Additional Benefits:
Approximately 80 percent of mutual fund purchases are made through
broker-dealers or other financial professionals, such as financial
planners and pension plan administrators. Prior to 1980, the
compensation that these financial professionals received for assisting
investors with mutual fund purchases was paid either by charging
investors a sales charge or load or paying for such expenses out of the
investment adviser's own profits. However, in 1980, SEC adopted rule
12b-1 under the Investment Company Act to help funds counter a period
of net redemptions by allowing them to use fund assets to pay the
expenses associated with the distribution of fund shares. Under NASD
rules, 12b-1 fees are limited to a maximum of 1 percent of a fund's
average net assets per year.[Footnote 14]
Although originally envisioned as a temporary measure to be used during
periods when fund assets were declining, the use of 12b-1 fees has
evolved to provide investors with flexibility in paying for investment
advice and purchases of fund shares. Instead of being offered only
funds that charge a front-end load, investors using broker-dealers to
assist them with their purchases can now choose from different classes
of fund shares that vary by how the broker-dealer is compensated. In
addition to shares that involve front-end loads with low or no 12b-1
fee--typically called Class A shares, investors can also invest in
Class B shares that have no front-end load but instead charge an annual
1 percent 12b-1 fee paid a certain number of years, such as 7 or 8
years, after which the Class B shares would convert to Class A shares.
Other share classes may have lower 12b-1 fees but charge investors a
redemption fee--called a back-end load--if shares are not held for a
certain minimum period. Having classes of shares allows investors to
choose the share class that is most advantageous depending on how long
they plan to hold the investment.[Footnote 15]
Because 12b-1 fees are used in ways different than originally
envisioned, SEC is seeking public comment on whether changes to rule
12b-1 are necessary. In a proposal issued on February 24, 2004, SEC
staff noted that modifications might be needed to reflect changes in
the manner in which funds are marketed and distributed. For example,
SEC staff told us that rule 12b-1 requires fund boards when annually
re-approving a fund's 12b-1 plan, to consider a set of factors that
likely are not relevant in today's environment.
In the proposal, SEC also seeks comments on whether alternatives to
12b-1 fees would be beneficial. One such alternative would have
distribution-related costs deducted directly from individual customer
accounts rather than having fund advisers deduct fees from the entire
fund's assets for eventual payment to selling broker-dealers. The
amount due the broker-dealer could be deducted over time, say once a
quarter until the total amount is collected.[Footnote 16] According to
the SEC proposal, this alternative would be beneficial because the
amounts charged and their effect on shareholder value would be
completely transparent to the shareholder because the amounts would
appear on the shareholder's account statements. According to a fund
official and an industry analyst, having fund shareholders see the
amount of compensation that their broker is receiving would increase
investor awareness of such costs and could spur greater competition
among firms over such costs.
We commend SEC for seeking comments on potentially revising rule 12b-1.
Such fees are now being used in ways SEC did not intend when it adopted
the rule in 1980. We believe providing alternative means for investors
to compensate broker-dealers, like the one SEC's proposal describes,
would preserve the beneficial flexibility that investors currently
enjoy while also increasing the transparency of these fees. An approach
like the one SEC describes would also likely increase competition among
broker-dealers over these charges, which could lower the costs of
investing in fund shares further.
Regulators Respond to Revenue Sharing Payment Concerns:
Regulators have also acted to address concerns arising from another
common mutual fund distribution practice called revenue sharing.
Revenue sharing occurs when mutual fund advisers make payments out of
their own revenue to broker-dealers to compensate them for selling that
adviser's fund shares. Broker-dealers that have extensive distribution
networks and large staffs of financial professionals who work directly
with and make investment recommendations to investors, increasingly
demand that fund advisers make these payments in addition to the sales
loads and 12b-1 fees that they earn when their customers purchase fund
shares. For example, some broker-dealers have narrowed their offerings
of funds or created preferred lists that include the funds of just six
or seven fund companies that then become the funds that receive the
most marketing by these broker-dealers. In order to be selected as one
of the preferred fund families on these lists, the mutual fund adviser
often is required to compensate the broker-dealer firms with revenue
sharing payments. According to an article in one trade journal, revenue
sharing payments made by major fund companies to broker-dealers may
total as much as $2 billion per year. According to the officials of a
mutual fund research organization, about 80 percent of fund companies
that partner with major broker-dealers make cash revenue sharing
payments.
However, revenue sharing payments may create conflicts of interest
between broker-dealers and their customers. By receiving compensation
to emphasize the marketing of particular funds, broker-dealers and
their sales representatives may have incentives to offer funds for
reasons other than the needs of the investor. For example, revenue
sharing arrangements might unduly focus the attention of broker-dealers
on particular mutual funds, reducing the number of funds considered as
part of an investment decision--potentially leading to inferior
investment choices and potentially reducing fee competition among
funds. Finally, concerns have been raised that revenue sharing
arrangements might conflict with securities self-regulatory
organization rules requiring that brokers recommend purchasing a
security only after ensuring that the investment is suitable for the
investor's financial situation and risk profile.
Our June 2003 report recommended that SEC consider requiring that more
information be provided to investors to evaluate these conflicts of
interest; SEC and NASD have recently issued proposals to require such
disclosure. Although broker-dealers are currently required to inform
their customers about the third-party compensation the firm is
receiving, they have generally been complying with this requirement by
providing their customers with the mutual fund's prospectus, which
discloses such compensation in general terms. On January 14, 2004, SEC
proposed rule changes that would require broker-dealers to disclose to
investors prior to purchasing a mutual fund whether the broker-dealer
receives revenue sharing payments or portfolio commissions from that
fund adviser as well as other cost-related information. Similarly, NASD
has proposed a change to its rules that would require broker-dealers to
provide written disclosures to a customer when an account is first
opened or when mutual fund shares are purchased that describe any
compensation that they receive from fund advisers for providing their
funds "shelf space" or preference over other funds. SEC is also
proposing that broker-dealers be required to provide additional
specific information about the revenue sharing payments they receive in
the confirmation documents they provide to their customers to
acknowledge a purchase. This additional information would include the
total dollar amount earned from a fund's adviser and the percentage
that this amount represented of the total sales by the broker-dealer of
that advisers' fund shares over the 4 most recent quarters.
We commend SEC and NASD for taking these actions. The disclosures being
proposed by SEC and NASD are intended to ensure that investors have
information that they can use to evaluate the potential conflicts their
broker-dealer may have when recommending particular fund shares to
investors. However, such disclosures would likely also require
improving related investor education programs to better ensure that
investors understand the importance of these new disclosures.
SEC Has Also Proposed Eliminating Another Potential Mutual Fund
Conflict:
SEC has also taken another action to address a practice that creates
conflicts of interest between fund shareholders and broker-dealers or
fund advisers. On February 11, 2004, SEC proposed prohibiting fund
advisers from using trading commissions as compensation to broker-
dealers that sell their funds. Such arrangements are called "directed
brokerage," in which fund advisers choose broker-dealers to conduct
trades in their funds' portfolio securities as an additional way of
compensating those brokers for selling fund shares. These arrangements
represent a hidden expense to fund shareholders because brokerage
commissions are paid out of fund assets, unlike revenue sharing, which
is paid out of advisers' revenues. We support this action as a means of
better ensuring that fund advisers choose broker-dealers based on their
ability to effectively execute trades and not for other reasons.
Other Areas Requiring Continued SEC Attention:
SEC is considering actions to address conflicts of interests created by
"soft-dollar arrangements" and has taken actions to enhance disclosures
related to the costs of owning mutual funds, including considering
making more transparent costs included in brokerage transactions.
Although SEC has taken some actions, we believe that additional steps
could be taken to provide further benefits to investors by increasing
the transparency of certain mutual fund practices and enhancing
competition among funds on the basis of the fees that are charged to
shareholders.
Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact
Investors:
Soft dollar arrangements allow fund investment advisers to obtain
research and brokerage services that could potentially benefit fund
investors but also increase investor costs. When investment advisers
buy or sell securities for a fund, they may have to pay the broker-
dealers that execute these trades a commission using fund assets. In
return for these brokerage commissions, many broker-dealers provide
advisers with a bundle of services, including trade execution, access
to analysts and traders, and research products.
Soft dollar arrangements are the result of regulatory changes in the
1970s. Until the mid-1970s, the commissions charged by all brokers were
fixed at one equal price. To compete for commissions, broker-dealers
differentiated themselves by offering research-related products and
services to advisers. In 1975, to increase competition, SEC abolished
fixed brokerage commission rates. However, investment advisers were
concerned that they could be held in breach of their fiduciary duty to
their clients to obtain best execution on trades if they paid anything
but the lowest commission rate available to obtain research and
brokerage services. In response, Congress created a "safe harbor" under
Section 28(e) of the Securities Exchange Act of 1934 that allowed
advisers to pay more than the lowest available commission rate for
security transactions in return for research and brokerage services.
Although legislation provides a safe harbor for investment advisers to
use soft-dollars, SEC is responsible for defining what types of
products and services are considered lawful under the safe harbor.
Since 1986, the SEC has interpreted Section 28(e) as applying to a
broad range of products and services, as long as they provide 'lawful
and appropriate assistance to the money manager in carrying out
investment decision-making responsibilities.':
Some industry participants argue that the use of soft dollars benefits
investors in various ways. The research that the fund adviser obtains
can directly benefit fund investors if the adviser uses it to select
securities for purchase or sale by the fund. The prevalence of soft
dollar arrangements also allows specialized, independent research to
flourish, thereby providing money managers a wider choice of investment
ideas. As a result, this research could contribute to better fund
performance. The proliferation of research available as a result of
soft dollars might also have other benefits. For example, an investment
adviser official told us that the research on smaller companies helps
create a more efficient market for securities of those companies,
resulting in greater market liquidity and lower spreads, which would
benefit all investors including those in mutual funds.
Although the research and brokerage services that fund advisers obtain
through the use of soft dollars could benefit a mutual fund investor,
this practice also could increase investors' costs and create potential
conflicts of interest that could harm fund investors. For example, soft
dollars could cause investors to pay higher brokerage commissions than
they otherwise would, because advisers might choose broker-dealers on
the basis of soft dollar products and services, not trade execution
quality. Soft dollar arrangements could also encourage advisers to
trade more in order to pay for more soft dollar products and services.
Overtrading would cause investors to pay more in brokerage commissions
than they otherwise would. These arrangements might also tempt advisers
to "over-consume" research because they would not be paying for it
directly. In turn, advisers might have less incentive to negotiate
lower commissions, resulting in investors paying more for trades.
Regulators also have raised concerns over soft dollar practices. In
1996 and 1997, SEC examiners conducted an examination sweep into the
soft dollar practices of broker-dealers, investment advisers, and
mutual funds. In the resulting 1998 inspection report, SEC staff
documented instances of soft dollars being used for products and
services outside the safe harbor, as well as inadequate disclosure and
bookkeeping of soft dollar arrangements. SEC staff told us that their
review found that mutual fund advisers engaged in far fewer soft dollar
abuses than other types of advisers. To address the concerns
identified, the SEC staff report proposed recommending that investment
advisers keep better records and make greater disclosure about their
use of soft dollars. A working group formed in 1997 by the Department
of Labor (DOL) to study the need for regulatory changes and additional
disclosures to pension plan sponsors and fiduciaries on soft dollar
arrangements recommended that SEC act to narrow the definition of
products and services that are considered research and allowable under
the safe harbor.[Footnote 17] The working group also recommended that
SEC prepare a specific list of acceptable purchases with soft dollars
that included brokerage and research services.
Additional Actions to Address Conflicts Raised by Soft Dollars Could be
Beneficial:
Although SEC has acknowledged the concerns involved with soft-dollar
arrangements, it has taken limited actions to date. SEC staff told us
that the press of other business prevented them from addressing the
issues raised by other regulators and their own 1998 staff report.
However, in a December 2003 concept release on portfolio transaction
costs staff requested comments on what types of information investment
advisers should be required to provide to mutual fund boards regarding
the allocation of brokerage commissions for execution purposes and soft
dollar benefits.[Footnote 18] In addition, SEC staff told us that they
have formed a study group with representatives of the relevant SEC
divisions, including Investment Management, Market Regulation, and the
Office of Compliance Inspections and Examinations, to review soft
dollar issues. This group also is collecting information from industry
and foreign regulators.
Regulators in other countries and other industries have acted to
address the conflicts created by soft dollars. In the United Kingdom,
the Financial Services Authority (FSA), which regulates the financial
services industry in that country, has issued a consultation paper that
argues that these arrangements create incentives for advisers to route
trades to broker-dealers on the basis of soft dollar arrangements and
that these practices represented an unacceptable market
distortion.[Footnote 19] As a result of recommendations from a
government-commissioned review of institutional investment, FSA has
proposed banning soft dollars for market pricing and information
services, as well as various other products.[Footnote 20] FSA notes
that their proposal would limit the ability of fund managers to pass
management costs through their customers' funds in the form of
commissions and would provide more incentive to consider what services
are necessary for efficient funds management, both of which could lower
investor costs. However, FSA staff has acknowledged that restricting
soft dollar arrangements in the United Kingdom could hurt the
international competitiveness of their fund industry because fund
advisers outside their country would not have to comply with these
restrictions.
In addition, DOL has placed more restrictions on pension plan
administrators use of soft dollars than apply to mutual fund advisers.
SEC requires mutual fund boards of directors to review fund trading
activities to ensure that the adviser is obtaining best execution and
to monitor any conflicts of interest involving soft dollars. However,
section 28(e) allows fund advisers to use soft dollars generated by
trading in one fund's portfolio to obtain research that does not
benefit that particular fund but instead benefits other funds managed
by that adviser. In contrast, DOL requires plan fiduciaries to monitor
the plan's investment managers to ensure that the soft dollar research
obtained from trading commissions paid out of plan assets benefits the
plan and that the benefits to the plan are reasonable in relation to
the value of the brokerage and research services provided to the plan.
Some industry participants have also called on SEC to restrict soft
dollar usage. For example, the board of the Investment Company
Institute (ICI), which is the industry association for mutual funds,
recently recommended that SEC consider narrowing the definition of
allowable research under Section 28(e) and eliminate the purchase of
third-party research with soft-dollars. According to statements
released by ICI, SEC's definition of permitted research is overly
expansive and has been susceptible to abuse. ICI recommends that SEC
prohibit advisers from using soft dollars to obtain any products and
services that are otherwise publicly available in the marketplace, such
as periodical subscriptions or electronic news services. In a letter to
the SEC Chairman, ICI wrote that its proposal would reduce incentives
for investment advisers to engage in unnecessary trading and would more
closely reflect the original purpose of Section 28(e), which was to
allow investment advisers to take into account a broker-dealer's
research capabilities in addition to its ability to provide best
execution.
Beyond these proposals, some industry participants have called for a
complete ban of soft dollars. If soft dollars were banned--which would
require repeal of Section 28(e)--and bundled commission rates were
required to be separately itemized, fund advisers would not be allowed
to pay higher commissions in exchange for research. Advocates of
banning soft dollars believe that this would spur broker-dealers to
compete on the price of executing trades, which averages between $.05
and $.06 per share at large broker-dealers, whereas trades conducted
through other venues can be done for $.01 or less. Critics fear that
this ban would reduce the amount of independent research that advisers
obtain, which would hurt investors and threaten the viability of some
existing independent research firms.
To address concerns over soft dollars, our June 2003 report recommends
that SEC evaluate ways to provide additional information to fund
directors and investors on their fund advisers' use of soft dollars.
Because SEC has not acted to more fully address soft dollar-related
concerns, investors and mutual fund directors have less complete and
transparent information with which to evaluate the benefits and
potential disadvantages of fund advisers' use of soft dollars. However,
such disclosures could potentially increase the complexity of the
information that investors are provided and require them to interpret
and understand such information. As such, an enhanced investor
education campaign would also likely be warranted.
Although disclosure can improve transparency, it may not be sufficient
for creating proper incentives and accountability. In our view, the
time for SEC to take bolder actions regarding soft dollars is now.
Allowing the advisers of mutual funds to use customer assets to obtain
services that would otherwise have to be paid for using advisers'
revenues appears to create inappropriate incentives, and inadequate
transparency and accountability.
We commend SEC for initiating an internal study of soft dollar issues.
As part of this evaluation, we believe that SEC should consider at a
minimum the merits of narrowing the services that are considered
acceptable under the safe harbor. Concerns that SEC's current
definition of permitted research is overly expansive and susceptible to
abuse have been recognized for years. Acting to narrow the safe harbor
could reduce opportunities for abusive practices. It could also lower
investor costs by reducing adviser incentives to overtrade portfolio
assets to obtain soft dollar research and services. We also believe
that SEC's study should consider the relative merits of eliminating
soft dollar arrangements altogether. The elimination of soft dollars,
which would require legislative action, could create greater incentives
for broker-dealers to compete on the basis of execution cost and
greater incentives for fund advisers to weigh the necessity of some of
the research they now receive since they would have to pay for such
items from their own revenues.
New and Proposed Rules Could Provide Added Transparency of the Costs of
Investing in Mutual Funds:
SEC recently adopted rules and rule amendments aimed at increasing
investor awareness by improving the disclosures of the fees and
expenses paid for investing in mutual funds. In February 2004, SEC
adopted rule amendments that require mutual funds to make additional
disclosures about their expenses.[Footnote 21] This information will be
presented to investors in the annual and semiannual reports prepared by
mutual funds. Among other things, mutual funds will now be required to
disclose the cost in dollars associated with an investment of $1,000
that earned the fund's actual return and incurred the fund's actual
expenses paid during the period. In addition to allowing existing
investors to compare fees across funds, SEC staff indicated that
placing these disclosures in funds' annual and semiannual reports will
help prospective investors to compare funds' expenses before making a
purchase decision.
In addition to this action, SEC amended fund advertising rules in
September 2003 to require funds to state in advertisements that
investors should consider a fund's fees before investing and direct
investors to consult the fund prospectus for more information.[Footnote
22] Additionally, in November 2003, NASD proposed amending rules to
require that mutual funds advertising their performance present
specific information about the fund's expenses and performance in a
more prominent format. These new requirements are aimed at improving
investor awareness of the costs of buying and owning a mutual fund,
facilitating comparison of fees among funds, and make presentation of
standardized performance information more prominent. Specifically,
NASD's proposal would require that all performance advertising contain
a text box that sets forth the fund's standardized performance
information, maximum sales charge, and annual expense ratio. In doing
so NASD's proposal would go beyond SEC requirements by requiring funds
to include specific performance and expense information within
advertising materials.
Another cost-related rulemaking initiative by SEC staff seeks to
improve the disclosure of breakpoint discounts for front-end sales
loads. In March 2003, SEC, NASD, and the New York Stock Exchange issued
a report describing the failure of some broker-dealers to issue
discounts on front-end charges paid to them by mutual fund investors.
Mutual funds with front-end sales loads often offer investors discounts
or "breakpoints" in these sales loads as the dollar value of the shares
purchased by investors or members of their family increases, such as
for purchases of $50,000 or more. To better ensure that investors
receive these discounts when deserved, SEC is proposing to require
funds to disclose in their prospectuses when shareholders are eligible
for breakpoint discounts. According to the SEC proposal, such
amendments are intended to provide greater prominence to breakpoint
disclosure by requiring its inclusion in the prospectus rather than in
the Statement of Additional Information, which is a document delivered
to investors only upon request.
However, these actions would not require mutual funds to disclose to
each investor the specific amount of fees in dollars that are paid on
the shares they own. As result, investors will not receive information
on the costs of mutual fund investing in the same way they see the
costs of many other financial products and services that they may use.
In addition, these actions do not require that mutual funds provide
information relating to fees in the document that is most relevant to
investors--the quarterly account statement. In a 1997 survey of how
investors obtain information about their funds, ICI indicated that, to
shareholders, the account statement is probably the most important
communication that they receive from a mutual fund company and that
nearly all shareholders use such statements to monitor their mutual
funds.
Our June 2003 report recommends that SEC consider requiring mutual
funds to make additional disclosures to investors, including
considering requiring funds to specifically disclose fees in dollars to
each investor in quarterly account statements. SEC has agreed to
consider requiring such disclosures but was unsure that the benefits of
implementing specific dollar disclosures outweighed the costs to
produce such disclosures. However, we estimate that spreading these
implementation costs across all investor accounts might not represent a
large outlay on a per-investor basis.
Our report also discusses less costly alternatives that could also
prove beneficial to investors and spur increased competition among
mutual funds on the basis of fees. For example, one less costly
alternative would require quarterly statements to present the same
information--the dollar amount of a fund's fees based on a set
investment amount--recently required for mutual fund semiannual
reports. Doing so would place this additional fee disclosure in the
document generally considered to be of the most interest to investors.
An even less costly alternative would be to require that quarterly
statements also include a notice that reminds investors that they pay
fees and to check their prospectus and ask their financial adviser for
more information. Disclosures such as these could be the incentive that
some investors need to take action to compare their fund's expenses to
those of other funds and thus make more informed investment decisions.
Such disclosures may also increasingly motivate fund companies to
respond competitively by lowering fees.
This concludes my prepared statement and I would be happy to respond to
any questions at the appropriate time.
Contacts and Acknowledgements:
For further information regarding this testimony, please contact
Richard J. Hillman or Cody J. Goebel at (202) 512-8678. Individuals
making key contributions to this testimony include Toayoa Aldridge,
Barbara Roesmann, George Scott, and David Tarosky.
FOOTNOTES
[1] These statistics were reported by the Investment Company Institute
and the Federal Reserve Board.
[2] NASD oversees broker-dealers that sell mutual funds and other
securities to their customers.
[3] See U.S. General Accounting Office, Mutual Funds: Information on
Trends in Fees and Their Related Disclosure, GAO-03-551T (Washington,
D.C.: Mar. 12, 2003); Mutual Funds: Greater Transparency Needed in
Disclosures to Investors, GAO-03-763 (Washington, D.C.: June 9, 2003);
Mutual Funds: Additional Disclosures Could Increase Transparency of
Fees and Other Practices, GAO-03-909T (Washington, D.C.: June 18,
2003); and Mutual Funds: Additional Disclosures Could Increase
Transparency of Fees and Other Practices, GAO-04-317T (Washington,
D.C.: Jan. 27, 2004).
[4] The term "hedge fund" generally identifies an entity that holds a
pool of securities and perhaps other assets that does not register its
securities offerings under the Securities Act and which is not
registered as an investment company under the Investment Company Act of
1940. Hedge funds are also characterized by their fee structure, which
compensates the adviser based upon a percentage of the hedge fund's
capital gains and capital appreciation.
[5] SEC rule 22c-1, promulgated under the Investment Company Act of
1940, prohibits the purchase or sale of mutual fund shares except at a
price based on current net asset value of such shares that is next
calculated after receipt of a buy or sell order.
[6] See H.R. 2179, Securities Fraud Deterrence and Investor Restitution
Act of 2003.
[7] Securities and Exchange Commission, Amendments to Rules Governing
Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec. 11, 2003).
[8] A fund's transfer agent maintains records of fund owners.
Currently, the National Securities Clearing Corporation, which is the
clearing organization for securities trades in the United States, also
operates a system used by broker-dealers and others to transmit mutual
fund orders to fund companies.
[9] Fair value pricing is a process that mutual funds use to value fund
shares (such as for assets traded in foreign markets) in the absence of
current market values. The Investment Company Act of 1940 requires that
when market quotations for a portfolio security are not readily
available, a fund must calculate its fair value.
[10] Gartenberg v. Merrill Lynch Asset Management Inc., 528 F. Supp.
1038 (S.D.N.Y. 1981), aff'd, 694 F. 2d 923 (2d Cir. 1982), cert.
denied, 461 U.S. 906(1983).
[11] J.P. Freeman and S.L. Brown, "Mutual Fund Advisory Fees: The Cost
of Conflicts of Interest," 26 Journal of Corporation Law 609 (2001).
[12] Securities and Exchange Commission, Proposed Rule: Investment
Company Governance, Release No. IC-26323 (Jan.15, 2004).
[13] U.S. Comptroller General David M. Walker, Integrity: Restoring
Trust in American Business and the Accounting Profession (document
based on author's speech to the American Institute of Certified Public
Accountants), Nov. 2002.
[14] Specifically, NASD rules limits the amount of 12b-1 fees that may
be paid to broker-dealers to no more than 0.75 percent of a fund's
average net assets per year. Funds are also allowed to include an
additional service fee of up to 0.25 percent of average net assets each
year to compensate sales professionals for providing ongoing services
to investors or for maintaining their accounts.
[15] Concerns over whether broker-dealers are helping investors choose
the best type of fund shares for their needs have been raised recently.
For example, in May 2003, SEC took an enforcement action against a
major broker dealer that it accused of inappropriately selling mutual
fund B shares to investors who would have been better off buying
another class of shares.
[16] SEC's proposal provides an example where a shareholder purchasing
$10,000 of fund shares with a 5-percent sales load could pay a $500
sales load at the time of purchase, or could pay an amount equal to
some percentage of the value of his or her account each month until the
$500 amount was fully paid (plus carrying interest). If the shareholder
redeemed the shares before the amount was fully paid, the proceeds of
the redemption would be reduced by the unpaid amount.
[17] U.S. Department of Labor, Report of the Working Group on Soft
Dollars/Commission Recapture (Nov. 13, 1997) available at http://
www.dol.gov/ebsa/publications/softdolr.htm. DOL oversees pension
plans.
[18] SEC's concept release "Measures to Improve Disclosure of Mutual
Fund Transaction Costs" specifically requests comments on ways to
improve the qualification and disclosure of commission costs as well as
other transaction related costs.
[19] Financial Services Authority, Bundled Brokerage and Soft
Commission Arrangements (April 2003).
[20] P. Myners, Institutional Investment in the United Kingdom: A
Review (Mar. 6, 2001).
[21] Securities and Exchange Commission, Final Rule: Shareholder
Reports and Quarterly Portfolio Disclosure of Registered Management
Investment Companies, Release Nos. 33-8393; 34-49333; IC-26372 (Feb.
27, 2004).
[22] Securities and Exchange Commission, Final Rule: Amendments to
Investment Company Advertising Rules, Release Nos. 33-8294; 34-48558;
IC-26195 (Sep. 29, 2003).